The Alternative Investment Management Association director of government and regulatory affairs Jiri Krol says he has some concerns with the European Commission's Emir proposals on asset segregation in the over-the-counter derivatives market and sets out his wish list.

In the over-the-counter derivatives market today, clients of derivative dealers trade outside of regulated markets and bilaterally clear their contracts.

Bilateral clearing involves, in most instances, the client providing collateral as security against the fulfilment of their obligations in the form of initial margin payments (eg. cash or securities).

Collateral, as a default position, is often held in the accounts of the derivative dealer following title transfer or pledge of securities or payment of cash.

Furthermore, the dealer is often able to use the assets as their own - a 'rehypothecation' of assets. In this situation, if the derivative dealer were to become insolvent, the client's margin under insolvency law would form part of the insolvent estate of the dealer and the client would be left with a creditors' claim over their assets and could expect a reduced return on the value of assets provided (a pro rata creditors claim), and significant delay in receiving those assets whilst the dealer's business is wound up.

To address this issue, some buyside firms have negotiated (at reasonable cost) for their asset to be held independently of the dealer in a single account with a third party custodian ('fully segregated'), and for the dealer to have rights over the assets only as provided for under a tri-party custodian agreement (i.e. where a client is 'out of the money' under the derivatives contract). Should the dealer become insolvent, the assets would not be subject to insolvency proceeding and may be returned to the client promptly.

In the futures market, where contracts are often traded on exchange, central clearing services have been provided and collateral has been segregated from the dealer with the clearinghouse or with a third party custodian. Assets have been held in most cases collectively in a single independent account known as an 'omnibus' account. On the insolvency of a dealer, the exchange providing the central clearing service will seek to fulfil the obligations of the dealer to their clients - to do this they will be permitted to use assets posted as margin for the benefit of the dealer.

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